News & Analysis

CFOs: One in five businesses misrepresent earnings

Finance chiefs do not trust as much as 20 percent of reported company earnings, revealing a disconnect between GAAP and a company’s true financial performance, new research has found.   

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In a revelation that could impact target company due diligence for private equity managers, a new research paper from business professors at Emory University and Duke University shows that chief financial officers (CFOs) believe a whopping 20 percent of firms intentionally misrepresent their earnings using their own discretion with the generally accepted accounting principles (GAAP).

The survey, conducted by Ilia Dichev of Emory University, John Graham and Campbell Harvey of Duke University and Shiva Rajgopol of Emory and Columbia University, polled 375 CFOs—206 from private firms and 169 from public companies.

To gauge the prevalence of earnings misrepresentation, researchers asked the CFOs, “From your impressions of companies in general, in any given year, what percentage of companies use discretion within GAAP to report earnings which misrepresent the economic performance of the business?__%.”

Results reveal that on average CFOs believe that at any point in time about 20 percent of firms misrepresent performance, while private firms’ CFOs believe that the extent of earnings distortion even greater, closer to 30 percent. The magnitude of that misrepresentation is “quite material,” according to the survey – about 10 cents on every dollar. While most misrepresentation leads to the overstatement of earnings, one-third of firms are intentionally lowballing their earnings.

The findings suggest that CFOs see room for manipulation in US GAAP, and further believe that company executives are exploiting the wiggle room. The most popular reasons for earnings misrepresentation are the desire to influence stock price; internal and external pressures to hit targets; and executive compensation and career concerns, the survey found.

The survey authors supplemented the data with 12 anonymous, in-depth interviews with CFOs at large firms, which revealed that several felt sell-side analysts are not particularly good at detecting earnings management. One CFO went so far as to say “analysts usually don’t actively detect poor earnings quality. The good ones do but the sell side has no incentive to detect earnings quality.”